An offshoring expert argues that companies could compete and profit best by outsourcing to small, more developed countries.

The global financial crisis and the resulting slowdown of international growth have given business leaders a breather to reconsider the future direction of offshoring. That’s a good thing, because companies have often failed to conduct disciplined analyses and, as a result, viewed offshoring as a foolproof panacea: a low-cost, high-return strategy that lets them shift overseas everything from information technology to manufacturing and call centers — with no offsetting costs or disadvantages.

But as time goes on, they are sacrificing more and more as they follow the offshoring fashion. For one thing, cost savings are transitory. Wages keep rising in China and India, by as much as 20 percent a year for some jobs. And personnel turnover is at abnormally high levels — at call centers in China and India, as much as 80 percent of the workers have to be replaced each year; as a result, training is anything but a negligible expense.

But more important, costs aren’t the only criteria to consider. Increasingly, offshoring is used to transfer overseas such brainy jobs as financial research, analytics, chip design, legal services, clinical trials management, and even magazine or book editing. Given that activity is trending from low-level to high-order functions, countries such as India and China known best for cheap labor and large populations become less and less attractive. Their overall subpar literacy and productivity levels, the endemic weaknesses in their educational systems, and their minimal environmental regulations make these nations ill-suited for high-end tasks, which companies must increasingly rely on as a potential competitive distinction and a way to differentiate themselves in the knowledge-based economy.

In this new landscape, offshoring to smaller, more developed countries such as Taiwan, Singapore, and Estonia — places with higher labor costs but better workforce quality, productivity, and political security — may be a more suitable option. If nothing else, these nations offer an alternative that companies should consider by conducting more sophisticated risk–reward assessments of offshoring opportunities.

In offshoring location studies, a large population has often been considered a positive factor, since it implies a reservoir of available, low-cost talent. Further analysis, however, reveals that the number of people in a country — or even the annual number of college graduates — says little about the quality of the workforce. For example, China’s population is 16 times larger than that of the Philippines, but its pool of suitable, young, English-speaking engineers is only three times as big. The situation is similar in India. There the number of recent graduates exceeds, in gross terms, that of China and the United States combined. With approximately 230 state-accredited universities and 458 engineering colleges, India mass-produces 2.5 million graduates for the labor market each year. Yet only about 2 to 5 percent of India’s existing workforce has basic vocational skills, compared with 96 percent in South Korea, 75 percent in Germany, and 68 percent in the U.S., according to Indian government reports.

From another perspective, whereas 50 percent of the engineers in Hungary or Poland have the language skills, practical knowledge, or appropriate cultural attitudes to work for multinational companies, only 10 and 25 percent of the engineers in China and India, respectively, do, says Diana Farrell, deputy director of the U.S. National Economic Council, in Offshoring: Understanding the Emerging Global Labor Market (Harvard Business Press, 2006).

Finally, India, with a population of 1.1 billion, has the highest absolute number of people receiving very little education. Its literacy rate of 61 percent compares unfavorably with that of Singapore (92.5 percent), Taiwan (96.1 percent), and Estonia (99.8 percent). All of this raises a question: Since only a small, elite segment of the Indian and Chinese populations can legitimately compete with U.S. and E.U. workers, does population size really matter in offshoring comparisons when assessing a smaller location like Taiwan? Probably not.

Taiwan has virtually no natural resources, but it has developed substantial human resources of energy, ambition, and talent. And that talent was on display in a 2006 educational survey by the Organisation for Economic Co-operation and Development’s (OECD) Program for International Student Assessment, which examined the performance of 400,000 students in 57 countries, accounting for 90 percent of the world’s economy. Taiwan placed first in mathematics and fourth in science. This sort of brainpower drives Taiwan’s world-class electronics and chip design sectors and makes the small country a perfect offshoring location for knowledge-based activities well into the future.

Labor productivity is another critical factor that has gotten short shrift in offshoring decisions — an important oversight, given the relatively poor ranking of China and India. According to the OECD, China’s GDP per hour worked is only about 8 percent of that of the U.S., and India’s is 7 percent. By contrast, Estonia’s is 40.8 percent and Slovakia’s is 53.4 percent. The impact of this productivity gap was illustrated best by the experience of a global bank that set up a wealth management analytics team in India to provide equity research for private banking clients. At first the team seemed like a bargain: Indian research analysts were paid quite a bit less than their counterparts in London or New York. Yet, when bank executives examined productivity metrics, they made a troubling discovery: Although the Indian analysts were equal to or slightly better than their global colleagues in mathematical modeling, they were well below average in synthesizing the data, as well as in writing and producing the actual research and recommendations. This turned out to be a productivity cost not recognized prior to the launch.

An even more refined view of predicting output is provided by the U.N. Development Program’s human development index (HDI), a composite measurement that assesses a country’s average achievements in three basic areas: health, knowledge, and living standards. The HDI was created to emphasize that people and their capabilities, not basic economic growth figures, should be the ultimate criteria for assessing the strength and development of a country. Since the HDI measures human development at the macro level, a high score could indicate that a country is a sustainable environment for knowledge worker outsourcing. This is chiefly because poor health and sanitary conditions create security risks and impact worker productivity, and the lack of education affects on-the-job performance. In the 2009 HDI report, Singapore ranked 23rd in the world and Estonia came in at number 40, whereas China trailed at 92 and India at 134 (just ahead of the Democratic Republic of the Congo, Cambodia, and Myanmar [Burma]).

Social stability should count as well. A nation roiled by economic and environmental unease does not hold out much hope that its workers will be reliable and industrious, not to mention creative or self-motivating. Again, India, the number one offshoring location today, ranks poorly. It is essentially two different countries — a small part of its population generates GDP roughly as high as Mexico’s, but the rest has the GDP (as well as the inflation and malnutrition rates) of sub-Saharan Africa. India’s much-trumpeted “demographic dividend” — the population surge that will increase its workforce to 800 million by 2016 — may turn out to be more of a threat than an opportunity. India has 18 percent of the world’s population but only 4 percent of its fresh water and slightly more than 2 percent of its land area. Many of the country’s aquifers are already in critical condition. Moreover, India imports 70 percent of its oil from the Middle East and has no strategic reserves.

China is similarly challenged. Approximately 300 million people nationwide have no access to clean water. Furthermore, more than 700 million Chinese drink water that is below World Health Organization standards. According to the Water Environment Partnership in Asia, almost all of the nation’s rivers are polluted and 90 percent of urban water bodies are severely polluted.

The new criteria for knowledge-driven offshoring will be skills, talent availability, productivity, and sustainable working environments rather than labor cost advantages and massive worker pools. A more refined and sophisticated use of broader metrics will be necessary for companies to reach informed offshoring location decisions focused on sustainability. In a world of choice, this approach will surely make smaller, high-quality countries more attractive destinations.

Author PROFILE:

Kevin D. Stringer is a visiting professor at Thunderbird School of Global Management and a lecturer at the Swiss Finance Institute. He was formerly responsible for the development of offshoring strategy at UBS.

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